April 5, 2018
Author: Daniyal Inamullah, CFA
Exploration and production (“E&P”), commonly referred to as the ‘upstream’ portion of the energy industry value chain, includes activities related to the exploration, exploitation, and production of certain oil and gas resources. The process to value companies that operate in this portion of the oil and gas industry requires a thorough understanding of alternative valuation techniques, the energy industry value chain, and the current geopolitical climate.
In this blog, we discuss some of the key nuances in valuing oil and gas companies and how different techniques may be applied based on the pricing environment.
Guideline Public Company Market Multiples
Fundamental to the market approach for valuing a business is the selection of guideline public companies (“GPC”) to determine baseline trading multiples. As part of this selection process, GPCs are screened for criteria relevant to the industry being analyzed and the entity being valued. Relevant criteria for GPCs in oil and gas, however, are more idiosyncratic and require further differentiation. These include:
- Geographical allocation of a GPC’s assets;
- Production strategy (e.g., conventional versus unconventional);
- Ratio of oil to natural gas (either in terms of the amount of reserves or production);
- Cost of capital for oil and gas properties (based on reserve categories as defined by the Society of Petroleum Evaluation Engineers and the ratio of developed to total proven reserves);
- The reserves-to-production (“RP”) ratio; and
- Estimated production growth.
Furthermore, rather than using the typical EV/EBITDA or P/E multiples, analysts in oil and gas instead use the following:
- Enterprise Value (“EV”) to Reserves (SEC filings will typically only highlight proven reserves and international regulations may have different rules for how these reserves are presented);
- EV to Average Daily Production (future production estimates based on consensus estimates may be used in cases were current year production is unclear or may materially change over the next year); and
- EV to EBITDAX (adjustments may be required to reconcile between successful efforts and full cost accounting methods)
Guideline Transaction Multiples
Another common valuation method involves analyzing transaction multiples of acquisitions. While the selection process and criteria for comparable transactions is similar to that of GPCs, additional considerations must be made, including:
- Oil and natural gas commodity prices and price curves at the time of the transaction;
- Nature of the deal (i.e., asset deal vs. corporate transactions multiples);
- Strategy for acquired assets (i.e., high-grade and sale of residual vs. slow development); and
- Value differential for acquired acreage versus flowing production.
PV-10 Analysis (i.e., the Income Approach)
A PV-10 analysis refers to the estimation of the value for oil and gas assets based on the projection of future cash flows, discounted at an annualized rate of 10.0 percent (a standard rate applied pursuant to SEC reporting requirements for oil & gas assets). The basis for this analysis is a “reserve report” prepared by specialized petroleum and/or reserve engineering firms (such as Ryder Scott or NSAI). To estimate a fair value of the reserves, the valuation analyst must consider:
- The pricing scenario used in the revenue forecast (examples include the SEC strip curve – a backward looking average price used for SEC filings, NYMEX strip prices based on the futures curve, Wall Street consensus estimates, and internally developed models);
- Required capital expenditures for each respective reserve category (a budget known as an authority for expenditure (“AFE”) is required to be approved prior to any drilling operations);
- Asset retirement obligations (i.e., plugging & abandonment costs);
- The estimated useful life of the reserves;
- Ownership structure for the investment(s) (e.g., working versus mineral interest); and
- Risk-adjustment factors for different reserve categories.
Commodity Pricing and its Impact on Value
To demonstrate how the above techniques/concepts tend to change over time, we analyzed the relationship between growth of the EV and debt-adjusted cash flows (“DACF”) for US oil and gas E&P companies (See Exhibit B for supporting charts). Based on spot prices for oil (WTI) and natural gas (Henry Hub), we observed three distinct time periods known as “Before Crash”, “Crash” and “Recovery” (please see footnotes for definitions of these periods)1. In addition, we separated oil and natural gas companies based on each company’s respective oil mix ratio.
The findings illustrate that, during rising price environments, the relationship between EV and DACF is stronger for both separated oil and natural gas companies. In these rising price environments, both market and acquisition multiples are strong indications of value. In the Recovery period, however, multiples exhibit a weaker correlation with value. Therefore, valuation analysts should rely more on variations of the income and cost approaches. Both oil and natural gas companies exhibit this relationship. We note, however, that natural gas companies have not exhibited the same resurgence in the strength of the EV to DACF relationship. This differing relationship could be explained by multiple factors, including natural gas prices not recovering as quickly as oil prices (excluding the final two days of 2017), abnormally moderate winters over the last three years, inefficiencies in infrastructure for LNG trade, and/or other factors unique to the natural gas industry.
Exhibit A – Correlation Data Between Change in Enterprise Value and Debt-Adjusted Cash Flow 2,3,4
Exhibit B – Historical Spot Prices (Split by Period)5
 Before Crash Period reflects oil and natural gas dates from 12/31/2011 through 8/31/2014, Crash Period reflects dates from 8/31/2014 through 2/28/2016, and Recovery Period reflects dates from 2/28/2016 through 12/31/2017.
 Companies selection based on mid-cap companies (range of $2-$10 billion market capitalization) traded on a major US exchange. Oil specific companies include companies with an oil mix percentage above 40.0 percent. Natural gas specific companies include companies with an oil mix percentage less than 40.0 percent. For periods where companies were not publicly traded, they were excluded from the analysis.
 Oil Companies include: Callon Petroleum, Crescent Point Energy Corp., Enerplus Corporation, Kosmos Energy Ltd., Matador Resources Corporation, Murphy Oil Corporation, Oasis Petroleum, Inc., QEP Resources, Inc. and Whiting Petroleum Corporation.
 Natural Gas Companies include: Antero Resources Corporation, Cimarex Energy Co., CNX Resources Corporation, Laredo Petroleum, Inc., Newfield Exploration Company, PDC Energy, Inc., Range Resources Corporation, SM Energy Company and SRC Energy Inc.
 Source: S&P Capital IQ, US Energy Information Administration, and the St. Louis Federal Reserve database.